incomplete contracts and corporate governance theory and evidence---case studies on chinese banking and u.s. franchising

Incomplete Contracts and Corporate Governance:
Theory and Evidence
Case Studies on Chinese Banking and U.S. Franchising





by

CHEN Shaoling





A Thesis Submitted to
The Hong Kong University of Science and Technology
in Partial Fulfillment of the Requirements for
the Degree of Doctor of Philosophy
in the Department of Economics,
School of Business and Management



August 2007, Hong Kong

HKUST Library
Reproduction is prohibited without the author’s prior written consent

3306803

3306803

2008
iv
Acknowledgements
I am deeply grateful to my supervisor, Susheng WANG, who has been a warm,
generous, and highly intelligent mentor over time and has supervised more than just
the product itself. Professor WANG took an active concern with the development of
this thesis, annotating it with many excellent suggestions, and extending my
intellectual horizons in terms of method and purpose. My appreciation to Professor
WANG for his practical advice and continuing encouragement throughout my entire
graduate education is immeasurable.

An unparalleled gratitude must be extended to all members of my thesis committee,
Professors Jiahua CHE, Xinyu HUA, Sudipto DASGUPTA, and Steven WEI (Hong
Kong Polytechnic University) for reading such a lengthy thesis, and for providing
many helpful discussions of the topic, which brought this thesis to fruition.

I would like to thank all of my instructors, in particular Professors Songnian CHEN,
In CHOI, Leonard K CHENG, Danyang XIE, Jaehyon NAHM, as well as Professor
Stephen Y CHIU (University of Hong Kong) for introducing me to the rewarding and
challenging world of economic research in HKUST. Without the time and energy
they contributed to my academic career, this thesis could not have been made.

My warmest appreciation goes to my fellow students for their generosity, insight and
friendship. I cannot list all from whom I obtained invaluable information and ideas,
but I would like to mention Jun WU, Jin ZHANG, Lin GENG and Ping SHU for
seeing me through to the end, for being my biggest supporter, and for surrounding
me with positive energy and love.

And most of all, this thesis is dedicated to my parents, to whom I owe everything, for
enriching my life with tireless commitment, support and confidence; and to my
husband, Haisheng YANG, for creating an atmosphere of love in which hard work
became easy.
v
Table of Contents

Title Page i
Authorization Page ii
Signature Page iii
Acknowledgements iv
Table of Contents v
List of Tables vii
List of Figures viii
List of Charts x
Acronyms… xi
Abstract… … xi
Chapter 1 Introduction 1
Chapter 2 What Drives Recent Changes in the Control Structure of Chinese Banks 5
2.1 Introduction 5
2.1.1 One Reaction to Four Facts 5
2.1.2 Literature Review 10
2.1.3 My Contributions 11
2.2 Model 12
2.2.1 Decentralized Hierarchy 15
2.2.2 Centralized Hierarchy 17
2.2.3 Specifications and Solutions 20
2.3 Main Conclusions 24
2.3.1 Opening Up of Banking Market 24

2.3.2 Reform of Going Public 27
2.3.3 Increasing Serious Financial Frauds 30
2.3.4 Persistent High Ratio of NPLs 32
2.3.5 Major Determinant: A Comparison among Four Facts 36
2.4 Minor Results 40
2.4.1 Choice of Control Structure 40
2.4.2 Job Satisfaction 45
2.4.3 Payment System 49
2.4.4 Testable Hypotheses 52
2.5 Concluding Remarks 53
Chapter 3 Dynamic Behaviors of Franchise Chains From a Combined Perspective of
Resource Scarcity and Agency Theory 55
3.1 Introduction 55
3.1.1 What’s franchising? 56
3.1.2 Literature Review 58
3.1.3 Contributions and Structure 63
3.2 The Two-Period Dynamic Model 65
3.2.1 Second-period Choice 69
vi
3.2.2 First-period Choice 74
3.3 General Properties 76
3.3.1 A Summary 77
3.3.2 Benchmark 82
3.4 Main Results 90
3.4.1 Choice of Governance Structure: Franchising vs. Integration 92
3.4.2 Dynamic Franchise Contract 100
3.5 Minor Results 108
3.5.1 Pricing 108
3.5.2 Franchisee’s Effort 110
3.5.3 Franchisor’s Effort 116

3.6 Empirical Implications 118
3.6.1 Proxies for Chain-specific Attributes 118
3.6.2 Proxies for Decision Variables 121
3.6.3 Concluding Testable Hypotheses 122
3.5 Concluding Remarks and Possible Extensions 126
Chapter 4 An Empirical Analysis on Strategic Interactions among Franchise Chains A
Spatial Econometric Approach 129
4.1 Introduction 129
4.2 Theoretical Background 135
4.2.1 Sources of Interactions 135
4.2.2 Theoretical Models for Strategic Interactions 137
4.2.3 Strategic Interactions among Franchise Chains 139
4.3 The Reduced-form Model of Spatial Strategy 143
4.3.1 The Spatial Econometric Models 143
4.3.2 Specification of the Spatial Weights Matrix 146
4.3.3 Estimation Methodologies 149
4.4 Data and Variables 152
4.4.1 Data Collection and Sample Descriptions 152
4.4.2 Measurement of Variables and Descriptive Statistics 159
4.5 Results and Discussions 161
4.5.1 Preliminary Specification Tests 161
4.5.2 Regression Results and Robustness Tests 164
4.5.3 Discussions 167
4.6 Conclusions and Comments 171
Appendix A Proofs of Propositions, Corollaries and Results 174
Appendix B Steps in Chinese Banking Reform (1994~2006) 194
Appendix C Requirements Proposed by CBRC on Corporate Governance for the Ownership
Restructuring Reforms of the SOBs 197
Appendix D Game Tree of the Two-period Dynamic Model 198
Appendix E Numerical Results of the Parametric Effects on Franchise chains 199

Reference… 226
List of Tables

Table 3.1 Concluding Testable Hypotheses 123
Table 3.2 Results of an Empirical Test for Our Theoretical Conclusions 124
Table 3.3 Explanatory Power of Three Models 125
Table 4.1 Industry Overview I: Units 154
Table 4.2 Industry Overview II: Monetary Contract Terms 155
Table 4.3 Descriptive Statistics for Dependent and Independent Variables 161
Table 4.4 Statistics of Specification Tests for Spatial Effects 162
Table 4.5 White’s Test for Heteroscedasticity 163
Table 4.6 MLE Results for the Spatial Regressions of All Three Variables 165
Table 4.7 Robustness Tests for Spatial Effects 166
Table 4.8 Robustness Tests for Non-spatial Effects 166

viii
List of Figures

Figure 2.1 The Effect of Market Share on Choice of Control Structures 26
Figure 2.2 The Effect of Bureaucracy on Choice of Control Structure 29
Figure 2.3 The Effect of Internal Control Ability on Choice of Control Structure 31
Figure 2.4 The Effect of External Uncertainty on Choice of Control Structure 34
Figure 2.5 The Effect of Loan Expansion Productivity on Choice of Control Structure 42
Figure 2.6 The Effect of Risk Control Productivity on Choice of Control Structure 43
Figure 2.7 The Effect of Risk Aversion on Choice of Control Structure 43
Figure 2.8 Effects on Choice of Control Structure: Risk-adjusted Profitability 45
Figure 2.9 The Effect of Internal Control Ability on Job Satisfaction 46
Figure 2.10 The Effect of External Uncertainty on Job Satisfaction 47
Figure 2.11 The Effect of Market Share on Job Satisfaction 47
Figure 2.12 The Effect of Bureaucracy on Job Satisfaction 48

Figure 2.13 The Effect of Local Productivity on Job Satisfaction 49
Figure 2.14 The Effect of Risk Aversion on Job Satisfaction 49
Figure 3.1 Effects of Branding Value on Choice of Governance Structure: Scenario 1 87
Figure 3.2 Effects of Branding Value on Choice of Governance Structure: Scenario 2 88
Figure 3.3 Effects of Branding Value on Choice of Governance Structure: Scenario 3 88
Figure 3.4 Effects of Branding Value on Choice of Governance Structure: Scenario 4 89
Figure 3.5 Initiating Franchising: Relative Importance of Franchisee’s Resources 93
Figure 3.6 Initiating Franchising: High Branding Value 94
Figure 3.7 Initiating Franchising: Low Financial Constraints on Business Starting-up 95
Figure 3.8 Contract Renewal: Complementary Team Work 96
Figure 3.9 Contract Renewal: Quick Response to Local Market 97
Figure 3.10 Contract Renewal: High Marginal Productivity 97
Figure 3.11 Contract Renewal: High Discounting Rate of Future Value 98
Figure 3.12 Contract Renewal: Strong Bargaining Power of Franchisor 98
Figure 3.13 Contract Renewal: Huge Breakdown Loss 99
Figure 3.14 Royalty Rate: Relative Importance of Franchisee’s Resources 105
Figure 3.15 Royalty Rate: Complementary Team Work 106
Figure 3.16 Royalty Rate: Marginal Productivity 106
Figure 3.17 Pricing: Demand Elasticity 109
Figure 3.18 Pricing: Marginal Productivity 109
Figure 3.19 Franchisee’s Effort: Marginal Contribution of Franchisee’s Resources 111
Figure 3.20 Franchisee’s Effort: Marginal Contribution of Franchisor’s Resources 112
Figure 3.21 Franchisee’s Effort: Branding Value 112
Figure 3.22 Franchisee’s Effort: Marginal Cost of Franchisee’s Resources 113
Figure 3.23 Franchisee’s Effort: Marginal Cost of Franchisor’s Resources 113
Figure 3.24 Franchisee’s Effort: Complementary Team Work 114
Figure 3.25 Franchisee’s Effort: Demand Elasticity 114
Figure 3.26 Franchisee’s Effort: Breakdown Loss 115
Figure 3.27 Franchisee’s Effort: Franchisor’s Bargaining Power 115
Figure 3.28 Franchisor’s Effort: Demand Elasticity 118

Figure E.1 Governance Structure: Relative Importance of Franchisee’s Resources 199
Figure E.2 Governance Structure: Branding Value 200
Figure E.3 Governance Structure: Financial Constraints 200
Figure E.4 Governance Structure: Complementary Team Work 200
Figure E.5 Governance Structure: Demand Elasticity 200
Figure E.6 Governance Structure: Marginal Productivity 201
ix
Figure E.7 Governance Structure: Discount Rate 201
Figure E.8 Governance Structure: Breakdown Loss 201
Figure E.9: Governance Structure: Franchisor’s Bargaining Power 201
Figure E.10 Royalty Rate: Relative Importance of Franchisee’s Resources 202
Figure E.11 Royalty Rate: Branding Value 203
Figure E.12 Royalty Rate: Financial Constraints 203
Figure E.13 Royalty Rate: Complementary Team Work 203
Figure E.14 Royalty Rate: Demand Elasticity 203
Figure E.15 Royalty Rate: Marginal Productivity 204
Figure E.16 Royalty Rate: Discount Rate 204
Figure E.17 Royalty Rate: Breakdown Loss 204
Figure E.18 Royalty Rate: Franchisor’s Bargaining Power 204
Figure E.19 Franchise Fee: Relative Importance of Franchisee’s Resources 205
Figure E.20 Franchise Fee: Branding Value 206
Figure E.21 Franchise Fee: Financial Constraints 206
Figure E.22 Franchise Fee: Complementary Team Work 206
Figure E.23 Franchise Fee: Demand Elasticity 206
Figure E.24 Franchise Fee: Marginal Productivity 207
Figure E.25 Franchise Fee: Discount Rate 207
Figure E.26 Franchise Fee: Breakdown Loss 207
Figure E.27 Franchise Fee: Franchisor’s Bargaining Power 207
Figure E.28 Pricing: Importance of Franchisee’s Resources 208
Figure E.29 Pricing: Importance of Franchisor’s Resources 209

Figure E.30 Pricing: Branding Value 210
Figure E.31 Pricing: Financial Constraints 210
Figure E.32 Pricing: Complementary Team Work 211
Figure E.33 Pricing: Demand Elasticity 211
Figure E.34 Pricing: Marginal Productivity 212
Figure E.35 Pricing: Discount Rate 212
Figure E.36 Pricing: Breakdown Loss 213
Figure E.37 Pricing: Franchisor’s Bargaining Power 213
Figure E.38 Franchisee’s Effort: Importance of Franchisee’s Resources 214
Figure E.39 Franchisee’s Effort: Importance of Franchisor’s Resources 215
Figure E.40 Franchisee’s Effort: Branding Value 216
Figure E.41 Franchisee’s Effort: Financial Constraints 216
Figure E.42 Franchisee’s Effort: Complementary Team Work 217
Figure E.43 Franchisee’s Effort: Demand Elasticity 217
Figure E.44 Franchisee’s Effort: Marginal Productivity 218
Figure E.45 Franchisee’s Effort: Discount Rate 218
Figure E.46 Franchisee’s Effort: Breakdown Loss 219
Figure E.47 Franchisee’s Effort: Franchisor’s Bargaining Power 219
Figure E.48 Franchisor’s Effort: Importance of Franchisee’s Resources 220
Figure E.49 Franchisor’s Effort: Importance of Franchisor’s Resources 221
Figure E.50 Franchisor’s Effort: Branding Value 222
Figure E.51 Franchisor’s Effort: Financial Constraints 222
Figure E.52 Franchisor’s Effort: Complementary Team Work 223
Figure E.53 Franchisor’s Effort: Demand Elasticity 223
Figure E.54 Franchisor’s Effort: Marginal Productivity 224
Figure E.55 Franchisor’s Effort: Discount Rate 224
Figure E.56 Franchisor’s Effort: Breakdown Loss 225
Figure E.57 Franchisor’s Effort: Franchisor’s Bargaining Power 225

x

List of Charts

Chart 2.1 Publicly Disclosed Financial Frauds in Chinese Banks (1987~2005) 8
Chart 2.2 Reported NPLs in Chinese SOBs 9
Chart 2.3 Market Share on Assets by Type of Institutions (1993~2005) 27
Chart 2.4 Beginning Years for Centralization and Going Public of the SOBs 29
Chart 2.5 Frequency of Financial Frauds—Internal Misconduct vs. External Finagler 32
Chart 2.6 Composition of Capital Source in Chinese NFI Sector
a
at End-2005 35
Chart 2.7 Structure of China’s Financial Sector at Q3-2006 (% of Total Assets) 35
Chart 2.8 Amount and Ratio of NPLs in each SOB (2000~2006) 36
Chart 2.9 Distribution of Financial Frauds among the SOBs (1987~2005) 38
Chart 2.10 Selected Performance Indicators of Each SOB 39
Chart 3.1 Percentage Change in Number of Chains (2003~2005) 55
Chart 3.2 Percentage Change in Franchised Units (2003~2005) 55

Acronyms

PBC: People’s Bank of China
SOBs: State-owned banks
Big Four: Big four state-owned banks
BOC: Bank of China
CCB: China Construction Bank
ICBC: Industrial and Commercial Bank of China
ABC: Agriculture Bank of China
JSCBs: Joint share commercial banks
CCBs: City commercial banks
NBFIs: Non-bank financial institutions
CBRC: China Banking Regulatory Commission

NFI Sector: Non-financial-institutional sector
AMCs: Asset management companies
NPLs: Non-performing loans
SOEs: State-owned enterprises
WTO: World Trade Organization
RST: Resource Scarcity Theory
AT: Agency Theory
IFA: International Franchise Association
IFAEF: International Franchise Association Educational Foundation
USDOC: United States Department of Commerce
BID: Branding-inherent Demand
SAR: Spatial Autoregressive
SMA: Spatial Moving Average
Bond: Bond’s Franchise Guide

xii
Incomplete Contracts and Corporate Governance:
Theory and Evidence
Case Studies on Chinese Banking and U.S. Franchising
by CHEN Shaoling

Department of Economics
School of Business and Management
The Hong Kong University of Science and Technology

Abstract

This thesis applies the incomplete contract approach to studying the corporate
governance in two cases: Chinese banking and U.S. franchising, both of which are
issues of great significance from either academic or industrial perspective, but

researches on them are still far from enough.

First, a wave of centralizing control rights has been widely observed in Chinese
banking recently. Based on a two-state incomplete contract model, we show that it’s
actually a reaction to the following four facts—the opening up of the banking market,
the reform of going public, the increasing serious financial frauds and the persistent
high ratio of non-performing loans—which happen almost at the same time.

Second, the mixed governance structure as well as the uniform and time-invariant
linear contract in franchising also confuses many economists. This thesis establishes
a two-period double-sided moral hazard model to study the dynamic decision making
on governance structure and contracting of a franchise chain. Our results suggest that
both resource scarcity theory and agency theory work but carry different weights in
xiii
different stages along the whole life. Moreover, the accumulation of branding value
brings helps remove the diversification of contracting across outlets as well as phases
in the long run.

Following this logic, we conduct an empirical analysis on the strategic interactions
among franchise chains. Using data of 351 U.S. franchise chains from 43 sectors in
2005, we find significant evidence for spatial effects among franchise chains.
Specifically, the coexistence of the complementary strategy in governance structure
and the substituting strategy in contracting is consistent with the observed
competition behavior and duopoly industrial structure in franchising.
1
Chapter 1
Introduction

Corporate governance is now a topic of considerable interest to a large and
expanding cross-section of the community, which, until fairly recently, was not a

topic that attracted enough attention from both academic and industrial applications.
However, recent events, such as the Enron scandal and other corporate governance
failures, have put it on the front pages of our main newspapers. Although none of us
welcomes this kind of painful result, it has highlighted the important role that
corporate governance plays in a modern economy and the consequences of getting it
wrong. And it has also strengthened the incentives for directors and policy-makers
alike to reassess the structures needed to produce high quality corporate governance.
CORPORATE GOVERNANCE deals with the ways in which suppliers of
finance to corporations assure themselves of getting a return on their investment
(Shleifer & Vishny, 1997). How can financiers be sure that they get anything but a
worthless piece of paper back from the manager after the initial funding has been
secured, especially when new information accrues and circumstances that are not
clearly conceptualized at onset arise? To answer it, we should draw most of our
attention to the examination of the decision making processes during which parties
may have dissonant preferences, which obviously could be understood
straightforwardly from an agency’s perspective.
The agency problem is an essential element of corporate governance, which
has been raised by Coase (1937) and more recently developed by Jensen and
Meckling (1976), Fama and Jensen (1983a, b), Williamson (1985), and Tirole (2006).
The essence of the agency problem is the separation of finance and management,
or—in more standard terminology—of ownership and control. The former stemmed
from financing the firm is linked with income rights, and so with formal control
rights; while the latter authorizes the real control rights to managers by attaching
them to the physical possession of assets due to their proprietary information.
2
Whether or not, control rights always stand in the core of all issues. The firm
therefore needs a governance structure that will solve the parties’ agency problem
through selecting a design of decision making processes, in particular a special class
of decision making processes—allocation of control rights. While in reality, most of
these decision making processes are fulfilled through a series of contracts

In recent years, the contract theory has become one of the most active fields
of research in contemporary microeconomics. Specifically, rather than the traditional
theory of complete contracts which is closely related to the theory of implementation
or mechanism design, the incomplete contracts approach pioneered by Grossman and
Hart (1986) and Hart and Moore (1990) as another branch can be more helpful to
answer questions proposed above. The advantage is, most future contingencies are
hard to describe and foresee ex ante, and as a result, complete contracts are
technologically infeasible and decisions on allocating residual control rights—i.e.,
the rights to make decisions under circumstances not fully foreseen by the
contract—should be made in ex ante contracting. The works by Agnion and Bolton
(1992), Hart (1995), and Hart and Moore (1998) are such examples applying the
incomplete contracts approach to explaining the efficiency of different allocations of
control rights. However, this incomplete contracts approach is still often criticized by
some researchers either because the situation in practice is much more complicated
than those simple allocation frameworks addressed in current models based on this
approach (Shleifer & Vishny, 1997), or because a clear definition of incomplete
contracts has not been agreed upon yet. One popular view is that incomplete contract
theorists restrict the class of contracts they consider to an ad hoc subset of complete
contracts which are renegotiable (Huberman & Kahn, 1988; Aghion, Dawatripont &
Rey, 1994; Chung, 1991; Rogerson, 1992; Hermalin & Katz, 1991 & 1993; Che &
Hausch, 1999). The problem of this is the difficulty in designing an implemented
renegotiation game without ineffective threat ex ante (Rubinstein & Wolinsky, 1992;
Tirole, 1999). Besides that, the incomplete contracts approach from this perspective
is basically same as the traditional complete contracts approach, which causes it to be
further inapplicable for the purpose of our study. While the label “incomplete
3
contracts” used in this thesis most refers to the class of models initiated by Grossman
and Hart (1986), which are mainly concerned about the optimal allocation of asset
ownership
1

as well as the control rights derived from it rather than about the specific
way—renegotiation process for example—to achieve it. In fact, we stress an efficient
design ex ante in the contract about allocations of both formal control rights and real
control rights on spot assets.
Two cases are studied here: Chinese banking and U.S. franchising. Partly due
to the Asian financial crisis, the corporate governance in this area’s financial sector
has received most attention in recent years (Oman, 2001; Goswami, 2001; Lin, 2001;
Malherbe & Segal, 2001; Classens & Fan, 2002; Arun & Turner, 2004). And given
the overwhelming role banks play in the financial system in China and the
widespread as well as dramatic banking reforms implemented in this nation, the
corporate governance in Chinese banking should also have no doubt to be one issue
of the greatest essence. However, relative to that in firms, the corporate governance
in banks has quite been ignored by researchers, especially by economic theorists.
Even outside emerging markets, this issue has not been discussed in the literature
until recently (Macey & O’Hara, 2001). Our study provides some creative insights
into recent changes in the corporate governance of Chinese banks which would shed
light on further productive works in this field. Specifically, based on a two-state
incomplete contract model, we analyze the allocation of control rights along the
hierarchy of a bank under uncertainty. The results indicate that such changes in the
control structure of Chinese banks are closely related to current fluctuations of their
own transformations and external competition environment.
The same incomplete contract approach is also applied to studying the
corporate governance in U.S. franchising, which as one typical governance structure
mixing the features of both contracts and corporate organizations has rarely been
taken into account since the prosperity during the period from late 1980s to mid
1990s, either in theoretical models or in empirical works relative to its outstanding
growth day by day. However, arguments about the mixed governance structure of

1
Therefore, sometimes studies on this branch are also called as “the property (or ownership) rights approach”.

4
franchise chains from the two mainstream theories—Resource Scarcity Theory (RST)
and Agency Theory (AT)—have never stopped ever since. In addition, the uniform
and time-invariant linear rule of revenue sharing in franchise contracts has still not
been well explained, especially from a dynamic perspective. Based on a two-period
double-sided moral hazard model with branding value as a capital stock of the
greatest importance, the thesis studies the dynamic decisions on governance structure
and contracting made by a franchise chain, which suggest that both RST and AT
matter in choosing governance structure but carry different weights in different
stages along the whole life. Moreover, the establishment of branding value brings
bargaining power to the franchisee in a long-run relationship which helps remove the
diversification of contracts across outlets as well as phases.
Finally, we close the study with an empirical analysis on strategic interactions
among franchise chains. Although such an issue, sometimes also referred to as
“reaction functions” among independent firms, seems to be passionately discussed in
traditional economic theories but remains untouched in empirical studies probably
due to lack of feasible econometric technologies, it becomes hot today by reason of
the rapid growth of spatial econometrics since 1990s. Using data of 351 U.S.
franchise chains from 43 sectors in 2005, we estimate a series of strategic
interactions on their governance structures and contract terms in this thesis.
Significant evidence for spatial effects among franchise chains is found. However,
the reaction strategies are different between governance structure and contracting
behavior. It provides a reasonable interpretation to the observed puzzle that even
outlets offering same products or service but with different brands are usually open
side by side, the coexistence of a few of man-sized chains and a large number of
median-sized chains could still be a stable equilibrium.
5
Chapter 2
What Drives Recent Changes in the Control Structure
of Chinese Banks?

2.1 Introduction
In the last over two decades, China has been through a “gradualist” but very
impressive reform in its banking system, especially in the state-owned banks (SOBs),
which replaced the monobank system with a multilayered system that separates
commercial lending, policy lending and central banking functions from one another
as well as transformed the SOBs from specialized state banks into state dominated
share holding companies. Such an institutional shake-up is being boosted step by step
through three main transformations: a) banking restructuring, containing the disposal
of non-performing loans (NPLs), recapitalization and rebuilding the ownership
structure as well as the corporate governance structure; b) reduction of government
interference, containing quantity and price liberalization as well as opening up to the
foreign competition and c) improved regulation and supervision. Among them, the
first transformation always attracts most attention in both industrial and academic
fields probably because it’s the only one combining the self choice of the banks into
the authority’s activity, and the focus of our article is exactly one major self
choice—choice of control structure to achieve better corporate governance. Although
it sounds less familiar relative to other transformations, it has been playing a
non-negligible role during the whole banking reform.
2.1.1 One Reaction to Four Facts
As shown in Appendix B, the transformation of control structure has been the
focus of the banking reform in China since 1994 as every change along this
transformation was always coupled with one significant step taken in other parts of
the banking reform. However, our study concentrates on the recent wave of
centralizing control rights since 2001, which could be characterized as follows:
6
—In 2001, the Industrial and Commercial Bank of China (ICBC) as pilot
began to try out the so-called oblate management in part of its municipal branches,
which strengthened the direct control rights of its provincial branches on all affiliates
instead of extending the decision chain vertically. In more detail, the municipal

branch in the capital city of each province was downgraded as a district branch and
all district branches, some of which used to be subordinated to the municipal branch,
are now subject to the provincial branch directly.
—In 2004, a large number of Chinese banks, represented by the Banks of
China (BOC) and the China Construction Bank (CCB), further collected some
control rights—mainly on credit extending—from the municipal branches to their
provincial branches or even their headquarters in order to push the oblate and vertical
management throughout the whole hierarchy. For example, in the big four SOBs (Big
Four), except for the examining and approval right on re-extended loans which is still
controlled by the municipal branch and that on loans with mortgages or collaterals in
amount of less than 100,000 Yuan which is assigned to the county branch, such a
decision making right on other kinds of loans especially those with large amounts or
extended to major customers was centralized up to the provincial branch or even a
higher level in the hierarchy. Managers at the lower level are only responsible for
recommending these good-sized projects but have no rights to determine which one
and how much should be financed
2
. In addition, with the withdraw of many county
affiliates, the decision making right on fixed loans—especially those financing
projects in steel, electroanalysis aluminum, real estate, automobile and other
over-invested sectors—was also centralized to the provincial branch; that on liquidity
loans is still controlled by the municipal branch but greatly constrained
3
. Besides
those, an even more centralized tendency was found in the BOC. In four of its
municipal branches in Shanghai, the examine and approval right on retail loans was
transferred to the provincial branch as well
4
. More commonly, such a wave of

2
Choice of Periodicity and Long-run Consistency: Credit Centralization and Policy Implications, 2006/08/12,
/>.
3
Global Investment Web, 2005/08/11,
4
Jiangsu Banking Association, 2006/03/17,
7
centralization is not the specific phenomenon attributed to the Big Four. In 2006, the
Bank of Communications announced to push a transformation changing its control
structure from a “divisional bank” towards a “flow bank” in the next three years,
which would centralize control rights of all municipal branches on their chief
appointments, operation decisions and expense allocations to the headquarter
5
.
Following these significant changes in the control structure of Chinese banks
recently, question here is what are the driving forces underlying. Our study suggests
that such a wave of centralization behaves like a reaction to the following four facts
which happened almost during the same period: the opening up of the banking
market, the reform of going public, increasing serious financial frauds and the
persistent high ratio of non-performing loans (NPLs).
Firstly, the Chinese banking market was agreed to be fully opened up to
foreign affiliates by the end of 2006, as one major assignment of China’s accession to
the World Trade Organization (WTO) in late 2001. However, during the period
towards this final objective, besides extending as more as possible branches
throughout the whole nation step by step, many foreign financial institutions have
engaged in competing for holding shares in Chinese banks (see more details in
Appendix B) as well as other non-bank financial institutions (NBFIs), such as the
insurance company, the fund management company and so forth.
Secondly, all SOBs have been through or are planning to carry out a

transformation of going public, most of which were actually driven by the state in
order to improve efficiency and governance. Recently, the pace of such a
transformation of the ownership structure was significantly speeded by the following
measurements: a) recapitalizing injection of $45 billions into the BOC and the CCB
in end of 2003 which was extended to ICBC in 2005 with an amount of about $15
billions
6
; b) establishments of the BOC Limited and the CCB Corporation in 2004 as
well as the ICBC Limited in 2005. All above ultimately led to the oversea listing of
the CCB in late 2005 followed by the IPOs of both the BOC and the ICBC in the

5
21
st
Century Business Herald, November 3
rd
, 2006.
6
Hang Seng Economic Monthly, 2007.
8
next year.
Thirdly, many serious financial frauds have been observed in Chinese banks
since 2000 which reached a peak around 2003 no matter measured with the
frequency or with the loss (see Chart 2.1). Technologically, such financial frauds are
referred to as operational risk events in line with the new Basel I accord. More
specifically, as pointed out by Ren’s survey in 2006, among all financial frauds
publicly disclosed since 2000, over 17 cases have a loss of more than 100,000 Yuan
and with a total amount of over 8.7 billion fund involved. Also, in 2004 there were
354 cases taking place in the five largest national banks including the four
state-owned banks and the Bank of Communications with an increase of 69% in the

total loss of that of the last year.
0
10
20
30
40
50
60
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Year
0
10000
20000
30000
40000
50000
60000
70000
80000
Frequency (#)
Loss (million Yuan)

Source: Author’s own calculations based on samples provided by Zhang (2004) & Sheng (2005).
Chart 2.1 Publicly Disclosed Financial Frauds in Chinese Banks (1987~2005)

Lastly, the NPLs of the SOBs which resulted in serious credit risk was so
huge that accounted for 2,175 billions Yuan, or about 40% of total loans, before 2000,
and still had a two-digit ratio higher than 15% by the end of 2004 (See Chart 2.2).
Although more than 80% of NPLs in the Big Four were caused by the government
intervention, the support of the SOEs, the low standard of legal system and the close

or merge of some industries including military industries
7
and so should not be paid
for by financial institutions themselves, it had really put a significant negative

7
Ba, 2004.
9
pressure on the performance of the SOBs, which left no schedule for them to wait for
the rescue from the government especially when competitions from foreign banks
have been so close.

Source: Cui, 2006; Xiao, 2006; Annual reports by CBRC.
a
García-Herrero et al., 2006.
Chart 2.2 Reported NPLs in Chinese SOBs

The basic reason for Chinese banks’ reaction in centralizing control rights to
above facts is to improve their self-control ability on risks through establishing a
healthier governance structure. We argue from the following three aspects. Firstly,
this tendency to centralization is widespread in almost all commercial banks
including the joint share commercial banks (JSCBs) and other NBFIs rather than the
SOBs only, implying that it’s more like a self-enforcing decision less regardless of
ownership structure. Secondly, during the whole process of this transition, the
biggest trouble is always the risk control, represented by the credit risk and the
operational risk, which becomes most urgent in the latest wave of banking reform.
It’s mainly because the approval of the new Basel accord in 2004 placed emphasis on
the risk control again by proposing further requirements for the capital adequacy to
the three main risks—credit risk, operational risk and market risk—individually in
the banking sector. Finally, such an upward movement of the control rights along the

0
500
1000
1500
2000
2500
End-1999 2000 2001 2002 2003 2004 2005 2006 Q1-2007
Year
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
Amount of NPLs
% of Total Loans
% of NPLs in Eastern Euro
p
e Banks
a

10
hierarchy is more consistent with the new requirements
8
of the corporate governance
proposed by the CBRC. Actually, as mentioned by Ba in 2004, the latest institution

restructuring reform aims to rebuild a healthy banking sector subject to good
corporate governance rather than write off NPLs simply.
2.1.2 Literature Review
As a whole, the latest trend to a centralized control structure in Chinese banks
has distinguished itself from other changes happened before as a transformation
towards efficient corporate governance, requiring the focus of researches to lean
towards the problems related to incentives and risk-sharing contained in the
transformations, with the centralization of control structure as a typical example.
However current researches on this field are still far behind consideration, especially
from the view of corporate governance.
In specific, except for a few domestic articles which mentioned it with just
general comments (Wang & Gao, 2002; Luo, Wang & Fang, 2002; Liu, 2004) as well
as an outline in the year book of each bank, the work by Ren (2006) is one
contributing study which proposed an oblate managerial structure characterized by
“Strong Headquarter—Weak Branch” as an efficient alternative to enhance the
control of operational risk, which is indeed a detailed practice of the centralized
control structure. Another useful work is the empirical study conducted by Cheng
and Fu (2006) which tested the correlation between such a centralized control
structure and the performance of commercial banks, concluding that no significant
impacts of the control structure were found on the performance. However, their study
used a sample of 100 commercial banks in Europe, U.S. and Asia
9
, which ignored the
special features of Chinese banks as well as the restructuring reform in them and so
caused a bias in their conclusions inevitably. Moreover, since this change in the
control structure as a guideline to the bank’s operation was usually found in the
bank’s operation manual rather than public media, even fewer studies are available in
foreign literature.

8

See Appendix C.
9
More specifically, the sample assigns only a weight of 1/3 to Asian banks.
11
Actually, for quite a long time, literature on Chinese banks’ reform usually
pay most attention to the state’s active operations in dealing with its historical and
social costs that have been paid by the SOBs for the transition, such as huge amount
of NPLs, extremely insufficient capital, lending behavior with obvious features of
planning economy, and so on (Bai & Wang, 1998; Naughton, 1998; Bonin, 1999;
Nanto & Sinha, 2002; Barth, Koepp & Zhou, 2004; Harmid, 2005; Podpiera, 2006),
as well as an assessment of these operations (García-Herrero, Gavilá & Santabárbara,
2006; García-Herrero & Santabárbara, 2004) and their impacts (Fung, Ho & Zhu,
2000; Park & Sehrt, 2001; Fu & Heffernan, 2005). Even though some people have
noticed the importance of corporate governance in China’s banking reform (Leung,
Liu, Shen, Taback & Wang, 2002; Hamid, 2005), they just described roughly some
movements in building healthy corporate governance implemented by either the
government or banks, such as deregulation of the financial sector, dilution of state
shares, creation of the board of directors, introduction of foreign investors and so
forth; while both the theoretical and empirical studies based on an analysis about its
microeconomic foundation still remain untouched.
2.1.3 My Contributions
One methodology useful for our analytical framework is the incomplete
contract approach which emphasizes the allocation of income rights and control
rights when there exists something uncertain which could not be contracted ex ante.
In the field of hierarchy theory, this methodology is often observed in analyzing the
government behavior within a hierarchy containing either central government and
local governments (Mishra & Anant, 2004), or government and its legal agent (Grajzl
& Murrell, 2007); but rarely found in examining the self choice of a
profit-maximizing agent, especially of a bank in a transitional financial system, since
it was proposed by Hart and Holmström in 1987. Nevertheless, the increasing

uncertainty in the environment surrounding Chinese banks suggests that the
incomplete contract approach incorporated in our model as an initial try in this field
would probably be one appropriate tool to provide a microeconomic foundation for
recent changes in Chinese banks’ control structures.